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The Effect of a Dividend Tax Hike

A few weeks ago the Senate Budget Committee passed its fiscal 2011 budget resolution.  I'll leave it to the others to hash out the overarching economic effects of tax increases.  Instead I'd like to opine for a few minutes on the effect of a dividend tax increase (a 164% hike at the top tier) on investment in the kind of utility infrastructure we need.

Economists on both sides of the tax issue agree: Incentives matter.  Consider this USA Today piece:

"Utility stocks used to be so solid that they were considered safe enough for widows and orphans. The industry's steady dividends and stable financial performance was perfect for those kinds of investors, who couldn't afford to take much risk.  With utility deregulation came a lot of uncertainty. But now, an increasing number of investors, interested in dividends, are looking again at utility stocks."

Investors have been attracted to utility stocks because they have been paying out higher dividends more reliably than many other types of companies.  But investors were attracted to dividends in part because of the relatively low tax rate - 15% since 2003.  Most investors don't see that kind of taxable income rate anywhere else.

But that low tax rate is set to expire at the end of this year.  President Obama advocated - in both his campaign and in his 2011 budget - a new dividend tax rate of 20%.  But the Senate Budget Committee would raise it to 39.6% - more than 2.5 times the current rate.  That much-higher rate is likely to become law, the Wall Street Journal reported in a worthwhile article that explains the nuances of the increase.

So if low dividend tax rates incentivized investors to put their money into utility stocks, what would a high dividend tax rate do? 

The Edison Electrical Institute reported this the other day:

"U.S. utility stocks, long a safe haven for many investors in the midst of worldwide economic unrest, may struggle to attract shareholders if a looming hike in federal taxes on dividend income becomes a reality. . . A dividend tax hike of [the magnitude proposed] could deal a heavy blow to utilities. . . And it could deter new capital investments in electricity infrastructure, such as transmission lines, renewable energy projects and new nuclear reactors."

The Tax Foundation just released a study on The Economic Effects of the Lower Tax Rate on Dividends.  Its key findings:

  • Corporate profits are subject to double taxation in the U.S.  The return on a new equity-financed investment is taxed under the corporate income tax and again under the individual income tax when received by investors as dividend payment or realized as capital gains. This double taxation discourages productive capital formation and ultimately reduces wages and living standards.
  • When the high dividend tax rate is considered in conjunction with the high U.S. corporate tax rate - the second-highest among OECD countries, exceeded only by Japan - concern over the competitiveness of the United States as a place to locate investment can only grow.

Who will be affected?

Everyone who owns dividend-paying stock.  Some people argue that the dividend tax hike will impact only the wealthiest Americans.  Yet according to a study released earlier this year by Ernst & Young, in 2007 among taxpayers reporting qualified dividends:

  • 61 percent were 50 and older
  • 30 percent were 65 and older
  • 65 percent had incomes less than $100,000
  • 36 percent had incomes less than $50,000

In fact, dividend-paying utility stocks have long been considered a relatively stable income-generating investment for people living on fixed incomes, in or near retirement.  Not the fat cats that some reports would like us to imagine.

Utilities. Utilities rely on investors, in part, to finance capital projects - new power plants and transmission lines, renewable energy projects, upgrades to water and wastewater facilities.  If investors are less attracted to dividend-paying utility stocks because of the much-higher dividend tax rate, utilities could have more difficulty financing important infrastructure projects.

All of us.  Even for those who don't own dividend-paying stock (or don't plan to), most everyone benefits from utility infrastructure - power plants, transmission lines, gas distribution pipes, water treatment plants, sewers.  A tax hike that would hurt utilities' ability to finance new infrastructure projects, then, would affect all of us.

What's your take?  Write a comment below -- no registration required.

Written on Wednesday, 09 June 2010 12:00 by Gary Yaquinto

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